Lavish Lifestyles and the Entrepreneurial Spirit: A Missing Consideration in Dismissals for Bad Faith under 11 U.S.C. §707(a)

Whether 11 U.S.C. §707(a) allows for the dismissal of a non-consumer individual chapter 7 case filed in bad faith—and if so, what constitutes bad faith—is a question that continues to vex the courts.  The four Circuits that have addressed the issue of whether a case filed by an individual debtor with primarily non-consumer (business) debts [1] can be dismissed for bad faith under §707(a) are split [2], [3] and lower court decisions on the matter are similarly diverse. [4]  The majority view appears to be that bad faith does constitute cause under §707(a) with many courts adopting either a “totality of the circumstances” or egregious conduct analysis. [5]  Under both approaches, the courts consider whether the debtor lives a “lavish lifestyle.” 

Several courts have found cause to dismiss a case for bad faith after determining that an individual business debtor could repay a significant dividend to creditors over five years if he would curtail his excessive expenses. [6]  In making these rulings, the courts have found the means to skirt the plain language of the Code, which excludes individual business debtors from the abuse and good faith provisions of §707(b), [7] and have tiptoed around the legislative history which explicitly prohibits considering ability to pay as “cause” under §707(a). [8]  These decisions appear to be in tension with the underlying policy reasons for treating individual business debtors and individual consumer debtors differently.  If embraced by more courts, such an interpretation of §707(a) threatens to interfere with bankruptcy’s broader economic objectives of encouraging innovation and investment by ensuring chapter 7 relief is available to individual business debtors.

There is obvious allure in dismissing an individual business debtor’s chapter 7 case for bad faith when a filing under chapter 13 or chapter 11 would result in a larger dividend to creditors.  First, the creditors’ recovery would clearly be maximized and their exposure to risk lessened.  Lessening creditors’ risk could have the added benefit of putting downward pressure on the cost of credit.  Secondly, holding individual business debtors to the same standard of living imposed on individual consumer debtors under §707(b)(1)-(2) appeals to our sense of fairness.  Why should individual business debtors be permitted to pay for luxury vehicles and second homes when the lifestyles of individual consumer debtors are hemmed in by the provisions of the means test?   

While the individual business debtor who spends $2,700.00 a month maintaining his yacht [9] but does not pay his creditors may not be a particularly sympathetic character, the provisions of the Code and the policy behind chapter 7 liquidations do not require him to be.  If he is willing to surrender his non-exempt property for distribution, a lavish lifestyle resulting from the income a debtor has been able to generate after the failure of his business should not be taken as evidence of bad faith.  To do so would require the individual with business debt to pay creditors of a failed venture from the earnings of a subsequent successful endeavor, creating a disincentive for entrepreneurial risk-taking.  Such a result undercuts the long-standing economic considerations that shape bankruptcy policy. [10]

The relief provided by a chapter 7 bankruptcy—allowing an individual with primarily business debt to exchange his nonexempt property for a discharge of his debt—encourages the kind of economic risk-taking that creates jobs, fosters innovation and rewards persistence.  That an individual business debtor may be denied the benefits of a liquidation simply because he has been able to bounce back from a failed venture could create perverse incentives: debtors may opt to file a bankruptcy immediately after the failure of their business, or they may be disinclined to get back into the ring if they know their future success will be for the benefit of their past creditors.  Worst of all, they may decide against taking the risk of starting a business altogether.  A good faith standard that ultimately penalizes a once-failed entrepreneur for subsequent success risks chilling the kind of business investment and innovation that bankruptcy protection is designed to encourage.

The Supreme Court’s decision in Local Loan Co. v. Hunt [11] supports the contention that individual business debtors are entitled to a chapter 7 discharge regardless of post-venture income and expenses.  The Court explains that the purpose of bankruptcy is to “relieve the honest debtor from the weight of oppressive indebtedness, and permit him to start afresh.” [12]  Though this language is often quoted in relation to the §707(b)(3) good faith requirement of a debtor with primarily consumer debts, the Court in Local Loan was actually addressing the individual business debtor.  The Court goes on to explain that the rationale behind bankruptcy is to provide the debtor with a fresh start “…free from the obligations and responsibilities consequent upon business misfortunes.  This purpose of the [bankruptcy] act has been again and again emphasized by the courts as being of public as well as private interest, in that it gives to the honest but unfortunate debtor who surrenders for distribution the property which he owns at the time of bankruptcy, a new opportunity in life and a clear field for future effort, unhampered by the pressure and discouragement of pre-existing debt.” [13] The bargain struck in a chapter 7 bankruptcy is a kind of quid pro quo—the debtor surrenders his non-exempt property for the benefit of his creditors in exchange for the discharge of the debt resulting from a failed business venture.  The entrepreneur is then free to re-enter the marketplace and try again, without the cloud of a past failure overhead. 

This debtor-friendly policy makes sense when taking into account that over 50% of small businesses fail within the first four years [14] and that a significant percentage of entrepreneurs attempt to start a business more than once. [15]  When viewed through the lens of encouraging investment and economic growth, the chapter 7 liquidation and discharge emerges as a businessperson’s safety net against long-term financial ruin.  The purpose of a chapter 7 liquidation in the case of an individual business debtor is precisely to allow the debtor another opportunity to succeed, recognizing that the economy benefits from the success of entrepreneurs.  By looking into the income, expenses and “lavishness” of an individual business debtor’s lifestyle after he has rehabilitated himself from a failed venture, the courts have conflated the Code’s treatment of debtors with primarily consumer debt and those with business debt and have overlooked the important role chapter 7 liquidation and discharge plays in encouraging the entrepreneurial spirit.